It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.But let me assure you, you ain't seen nothing, yet.

What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.

It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds. What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent. And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.

It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

And for more on mortgages... you know it's bad when the main stream media outlets start more accurately characterizing the mess. I was told that Jim Cramer blurted out on CNBC today that Fannie Mae, Freddie Mac, and Citigroup were all going bankrupt! Erin responded (paraphrasing), "Don't say that! That won't happen!" Cramer said (paraphrasing again), "Well, it's the truth. I know people don't want to talk about it publicly. Now I suppose they'll come after me like Enron did when I called Enron out publicly. Now there's gonna be arrows at my back like Enron. Thank god Enron went down before they could get to me."

Herb Greenberg's Market BlogREAD COMMENTS FROM READERS AT SITE Bottom-line: He Nailed It!

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2:11:23 PM December 6th, 2007 Permalink | Comments (119)

Even before this mortgage mess started, one person who kept emailing me over and over saying that this is going to get real bad. He kept saying this was beyond sub-prime, beyond low FICO scores, beyond Alt-A and beyond the imagination of most pundits, politicians and the press. When I asked him why somebody from inside the industry would be so emphatically sounding the siren, he said, “Someobody’s got to warn people.”

Since then, I’ve kept up an active dialog with Mark Hanson, a 20-year veteran of the mortgage industry, who has spent most of his career in the wholesale and correspondent residential arena — primarily on the West Coast. He lives in the Bay Area. So far he has been pretty much on target as the situation has unfolded. I should point out that, based on his knowledge of the industry, he has been short a number of mortgage-related stocks.

His current thoughts, which I urge you to read:

The Government and the market are trying to boil this down to a ’sub-prime’ thing, especially with all constant talk of ‘resets’. But sub-prime loans were only a small piece of the mortgage mess. And sub-prime loans are not the only ones with resets. What we are experiencing should be called ‘The Mortgage Meltdown’ because many different exotic loan types are imploding currently belonging to what lenders considered ‘qualified’ or ‘prime’ borrowers. This will continue to worsen over the next few of years. When ‘prime’ loans begin to explode to a degree large enough to catch national attention, the ratings agencies will jump on board and we will have ‘Round 2′. It is not that far away.

Since 2003, when lending first started becoming extremely lax, a small percentage of the loans were true sub-prime fixed or arms. But sub-prime is what is being focused upon to draw attention away from the fact the lenders and Wall Street banks made all loans too easy to attain for everyone. They can explain away the reason sub-prime loans are imploding due to the weakness of the borrower.

How will they explain foreclosures in wealthy cities across the nation involving borrowers with 750 scores when their loan adjusts higher or terms change overnight because they reached their maximum negative potential on a neg-am Pay Option ARM for instance?

Sub-prime aren’t the only kind of loans imploding. Second mortgages, hybrid intermediate-term ARMS, and the soon-to-be infamous Pay Option ARM are also feeling substantial pressure. The latter three loan types mostly were considered ‘prime’ so they are being overlooked, but will haunt the financial markets for years to come. Versions of these loans were made available to sub-prime borrowers of course, but the vast majority were considered ‘prime’ or Alt-A. The caveat is that the differentiation between Prime and ALT-A got smaller and smaller over the years until finally in late 2005/2006 there was virtually no difference in program type or rate.

The bailout we are hearing about for sub-prime borrowers will be the first of many. Sub-prime only represents about 25% of the problem loans out there. What about the second mortgages sitting behind the sub-prime first, for instance? Most have seconds. Why aren’t they bailing those out too? Those rates have risen dramatically over the past few years as the Prime jumped from 4% to 8.25% recently. seconds are primarily based upon the prime rate. One can argue that many sub-prime first mortgages on their own were not a problem for the borrowers but the added burden of the second put on the property many times after-the-fact was too much for the borrower.

Most sub-prime loans in existence are refinances not purchase-money loans. This means that more than likely they pulled cash out of their home, bought things and are now going under. Perhaps the loan they hold now is their third or forth in the past couple years. Why are bad borrowers, who cannot stop going to the home-ATM getting bailed out?

The Government says they are going to use the credit score as one of the determining factors. But we have learned over the past year that credit scores are not a good predictor of future ability to repay. This is because over the past five years you could refi your way into a great score. Every time you were going broke and did not have money to pay bills, you pulled cash out of your home by refinancing your first mortgage or upping your second. You pay all your bills, buy some new clothes, take a vacation and your score goes up!

The ’second mortgage implosion’, ‘Pay-Option implosion’ and ‘Hybrid Intermediate-term ARM implosion’ are all happening simultaneously and about to heat up drastically. Second mortgage liens were done by nearly every large bank in the nation and really heated up in 2005, as first mortgage rates started rising and nobody could benefit from refinancing. This was a way to keep the mortgage money flowing. Second mortgages to 100% of the homes value with no income or asset documentation were among the best sellers at CITI, Wells, WAMU, Chase, National City and Countrywide. We now know these are worthless especially since values have indeed dropped and those who maxed out their liens with a 100% purchase or refi of a second now owe much more than their property is worth.

How are the banks going to get this junk second mortgage paper off their books? Moody’s is expecting a 15% default rate among ‘prime’ second mortgages. Just think the default rate in lower quality such as sub-prime. These assets will need to be sold for pennies on the dollar to free up capacity for new vintage paper or borrowers allowed to pay 50 cents on the dollar, for instance, to buy back their note.

The latter is probably where the ’second mortgage implosion’ will end up going. Why sell the loan for 10 cents on the dollar when you can get 25 to 50 cents from the borrower and lower their total outstanding liens on the property at the same time, getting them ‘right’ in the home again? Wells Fargo recently said they owned $84 billion of this worthless paper. That is a lot of seconds at an average of $100,000 a piece. Already, many lenders are locking up the second lines of credit and not allowing borrowers to pull the remaining open available credit to stop the bleeding. Second mortgages are defaulting at an amazing pace and it is picking up every month.

The ‘Pay-Option ARM implosion’ will carry on for a couple of years. In my opinion, this implosion will dwarf the ’sub-prime implosion’ because it cuts across all borrower types and all home values. Some of the most affluent areas in California contain the most Option ARMs due to the ability to buy a $1 million home with payments of a few thousand dollars per month. Wamu, Countrywide, Wachovia, IndyMac, Downey and Bear Stearns were/are among the largest Option ARM lenders. Option ARMs are literally worthless with no bids found for many months for these assets. These assets are almost guaranteed to blow up. 75% of Option ARM borrowers make the minimum monthly payment. Eighty percent-plus are stated income/asset. Average combined loan-to-value are at or above 90%. The majority done in the past few years have second mortgages behind them.

The clue to who will blow up first is each lenders ‘max neg potential’ allowance, which differs. The higher the allowance, the longer until the borrower gets the letter saying ‘you have reached your 110%, 115%, 125% etc maximum negative of your original loans balance so you cannot accrue any more negative and must pay a minimum of the interest only (or fully indexed payment in some cases). This payment rate could be as much as three times greater. They cannot refinance, of course, because the programs do not exist any longer to any great degree, the borrowers cannot qualify for other more conventional financing or values have dropped too much.

Also, the vast majority have second mortgages behind them putting them in a seriously upside down position in their home. If the first mortgage is at 115%, the second mortgage in many cases is at 100% at the time of origination — and values have dropped 10%-15% in states like California — many home owners could be upside down 20% minimum. This is a prime example of why these loans remain ‘no bid’ and will never have a bid. These also will require a workout. The big difference between these and sub-prime loans is at least with sub-prime loans, outstanding principal balances do not grow at a rate of up to 7% per year. Not considering every Option ARM a sub-prime loan is a mistake.

The 3/1, 5/1, 7/1 and 10/1 hybrid interest-only ARMS will reset in droves beginning now. These are loans that are fixed at a low introductory interest only rate for three, five, seven or 10 years — then turn into a fully indexed payment rate that adjusts annually thereafter. They first got really popular in 2003. Wells Fargo led the pack in these but many people have them. The resets first began with the 3/1 last year.

The 5/1 was the most popular by far, so those start to reset heavily in 2008. These were considered ‘prime’ but Wells and many others would do 95%-100% to $1 million at a 620 score with nearly as low of a rate as if you had a 750 score. No income or asset versions of this loan were available at a negligible bump in fee. This does not sound too ‘prime’ to me. These loans were mostly Jumbo in higher priced states such as California.

Values are down and these are interest only loans, therefore, many are severely underwater even without negative-amortization on this loan type. They were qualified at a 50% debt-to-income ratio, leaving only 50% of a borrower’s income to pay taxes, all other bills and live their lives. These loans put the borrower in the grave the day they signed their loan docs especially without major appreciation. These loans will not perform as poorly overall as sub-prime, seconds or Option ARMs but they are a perfect example of what is still considered ‘prime’ that is at risk. Eighty-eight percent of Thornburg’s portfolio is this very loan type for example.

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

What I am telling you is not speculation. I sold BILLIONs of these very loans over the past five years. I saw the borrowers we considered ‘prime’. I always wondered ‘what WILL happen when these things adjust is values don’t go up 10% per year’.

Now we’re finding out. If you made it all the way to the bottom, you can see why I decided to run this. Feel free to post thoughts below. Mark will likely be personally responding to any comments.